Hatzius: Our most controversial call, that the Fed will keep short-term rates near zero through 2010 and, more likely than not, 2011 as well, rests on three pillars – slow growth, lower inflation & Fed’s dual mandate. Jan Hatzius: Our most controversial view remains that Fed officials will keep short-term rates near zero through 2010 and, more likely than not, 2011 as well. This forecast rests on three pillars:

a) A more "U-shaped" pattern for the recovery in GDP and employment in 2010, as the loss of the boost from the inventory cycle and fiscal stimulus outweigh the private sector healing, at least in the near term.

b) Lower inflation for any given level of GDP and employment, as our models say that inflation depends much more on the level than the change of the output/unemployment gap.

c) We take Fed officials at their word when they say that they pursue a dual mandate of inflation and maximum sustainable employment; in particular, the latter part of the mandate refers to the level of employment relative to potential, not the growth rate.

Our conviction in our Fed call remains high – less confidence in growth pillar – but more confidence in inflation & Fed’s dual mandate pillars. Hatzius cont’d: Where do we stand after the most recent data and Fed comments? a) We have become a little less confident in the low growth pillar. The nonmanufacturing ISM survey—which should be less affected by the inventory cycle than its factory counterpart—as well as the ongoing strength in the consumer spending data suggest that the growth of final demand might be picking up by more than built into our forecast.

This would likely mean somewhat faster growth in real GDP than the 2% in Q2 and 1½% in Q3/Q4 that we are currently forecasting. If so, the labor market would probably also recover a bit faster than our forecast, and the unemployment rate might well already have peaked. b) In contrast, our confidence in the inflation pillar has grown further. Most measures of underlying inflation have been very soft in recent months. The best illustration is probably the Dallas Fed’s trimmed-mean PCE index, a statistically based measure of core inflation that eliminates the most extreme price movements in each month. It has risen just 1.0% over the past year and only 0.6% (annualized) over the past 3 months.

Along similar lines, nominal wage growth has also slowed sharply in recent months, with average hourly earnings recording their first month-to-month fall since 2003 in March. c) We also feel very good about the policy pillar, especially following the FOMC minutes. They revealed that “nearly all” FOMC members were in favor of retaining the “extended period” language on interest rates; thus, other FOMC members disagree with KC Fed President Hoenig’s view that an early move to slightly higher rates is needed to prevent a renewed bubble. We were also struck by the view of “a few” members that tightening too early is more dangerous than tightening too late, given the zero bound on nominal rates. We couldn’t agree more.